Oil-exporters need to rethink their monetary policy regimes

I started writing this post on Monday, but I have had an insanely busy week – mostly because of the continued sharp drop in oil prices and the impact of that on particularly the Russian rouble. But now I will try to finalize the post – it is after on a directly related topic to what I have focused on all week – in fact for most of 2014.

Oil prices have continued the sharp drop and this is leading to serious challenges for monetary policy in oil-exporting countries. Just the latest examples – The Russian central bank has been forced to abandon the managed float of the rouble and effectively the rouble is now (mostly) floating freely and in Nigeria the central bank the central bank has been forced to allow a major devaluation of the country’s currency the naira. In Brazil the central bank is – foolishly – fighting the sell-off in the real by hiking interest rates.

While lower oil prices is a positive supply shock for oil importing countries and as such should be ignored by monetary policy makers the story is very different for oil-exporters such as Norway, Russia, Angola or the Golf States. Here the drop in oil prices is a negative demand shock.

In a country like Norway, which has a floating exchange rate the shock is mostly visible in the exchange rate – at least to the extent Norges Bank allows the Norwegian krone to weaken. This of course is the right policy to pursue for oil-exporters.

However, many oil-exporting countries today have pegged or quasi-pegged exchange rates. This means that a drop in oil prices automatically becomes a monetary tightening. This is for example the case for the Golf States, Venezuela and Angola. In this countries what I have called the petro-monetary transmission mechanism comes into play.

An illustration of the petro-monetary transmission mechanism

When oil prices drop the currency inflows into oil-exporting countries drop – at the moment a lot – and this puts downward pressure on the commodity-currencies. In a country like Norway with a floating exchange rate this does not have a direct monetary consequence (that is not entirely correct if the central bank follows has a inflation target rather than a NGDP target – see here)

However, in a country like Saudi Arabia or Angola – countries with pegged exchange rates – the central bank will effectively will have tighten monetary policy to curb the depreciation pressures on the currency. Hence, lower oil prices will automatically lead to a contraction in the money base in Angola or Saudi Arabia. This in turn will cause a drop in the broad money supply and therefore in nominal spending in the economy, which likely will cause a recession and deflationary pressures.

The authorities can offset this monetary shock with fiscal easing – remember the Sumner critique does not hold in a fixed exchange rate regime – but many oil-exporters do not have proper fiscal buffers to use such policy effectively.

The Export-Price-Norm – good alternative to fiscal policy

Instead I have often – inspired by Jeffrey Frankel – suggested that the commodity exporters should peg their currencies to the price of the commodity the export or to a basket of a foreign currency and the export price. This is what I have termed the Export-Price-Norm (EPN).

For commodity exporters commodity exports is a sizable part of aggregate demand (nominal spending) and therefore one can think of a policy to stabilize export prices via an Export-Price-Norm as a policy to stabilize nominal spending growth in the economy. The graph – which I have often used – below illustrates that.

The graph shows the nominal GDP growth in Russia and the yearly growth rate of oil prices measured in roubles.

There is clearly a fairly high correlation between the two and oil prices measured in roubles leads NGDP growth. Hence, it is therefore reasonable in my view to argue that the Russian central bank could have stabilized NGDP growth by conducting monetary policy in such a way as to stabilize the growth oil prices in roubles.

That would effectively mean that the rouble should weaken when oil prices drop and appreciate when oil prices increase. This is of course exactly what would happen in proper floating exchange rate regime (with NGDP targeting), but it is also what would happen under an Export-Price-Norm.

Hence, obviously the combination of NGDP target and a floating exchange rate regime would do it for commodity exporters. However, an Export-Price-Norm could do the same thing AND it would likely be simpler to implement for a typical Emerging Markets commodity exporter where macroeconomic data often is of a low quality and institutions a weak.

So yes, I certainly think a country like Saudi Arabia could – and should – float its currency and introduce NGDP targeting and thereby significantly increase macroeconomic stability. However, for countries like Angola, Nigeria or Venezueala I believe an EPN regime would be more likely to ensure a good macroeconomic outcome than a free float (with messy monetary policies).

A key reason is that it is not necessarily given that the central bank would respect the rules-of-the-game under a float and it might find it tempting to fool around with FX intervention from time to time. Contrary to this an Export-Price-Norm would remove nearly all discretion in monetary policy. In fact one could imagine a currency board set-up combined with EPN. Under such a regime there would be no monetary discretion at all.

The monetary regime reduces risks, but will not remove all costs of lower commodity prices

Concluding, I strongly believe that an Export-Price-Norm can do a lot to stabilise nominal spending growth – and therefore also to a large extent real GDP growth – but that does not mean that there is no cost to the commodity exporting country when commodity prices drop.

Hence, a EPN set-up would do a lot to stabilize aggregate demand and the economy in general, but it would not change the fact that a drop in oil prices makes oil producers such as Saudi Arabia, Russia and Angola less wealthy. That is the supply side effect of lower oil prices for oil producing countries. Obviously we should expect that to lower consumption – both public and private – as a drop in oil prices effectively is a drop in the what Milton Friedman termed the permanent income. Under a EPN set-up this will happen through an increase inflation due to higher import prices and hence lower real income and lower real consumption.

There is no way to get around this for oil exporters, but at least they can avoid excessive monetary tightening by either allowing currency to float (depreciate) free or by pegging the currency to the export price.

Who will try it out first? Kuwait? Angola or Venezuela? I don’t know, but as oil prices continue to plummet the pressure on governments and central banks in oil exporting countries is rising and for many countries this will necessitate a rethinking of the monetary policy regime to avoid unwarranted monetary tightening.

PS I should really mention a major weakness with EPN. Under an EPN regime monetary conditions will react “correctly” to shocks to the export prices and for countries like Russia or Anglo “normally” this is 90% of all shocks. However, imagine that we see a currency outflow for other reasons – for as in the case of Russia this year (political uncertainty/geopolitics) – then monetary conditions would be tightened automatically in an EPN set-up. This would be unfortunate. That, however, I think would be a fairly small cost compared to the stability EPN otherwise would be expected to oil exporters like Angola or Russia.

PPS I overall think that 80-90% of the drop in the rouble this year is driven by oil prices, while geopolitics only explains 10-20% of the drop in the rouble. See here.

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Toilet paper shortage is always and everywhere a monetary phenomenon

This is from Sky News:

Venezuelans have been hit by a chronic toilet paper shortage, leading to empty supermarket shelves and long queues to snap up the remaining rolls…When new stocks arrive at supermarkets customers have been rushing in to fill their trollies.

It started with a food shortage and now it is the lack of toilet paper that is the latest economic problem in Venezuela. It is pretty clear that Venezuela’s chronic shortages of essential goods are a result of the combination of excessively easy monetary policy and price controls.

If monetary policy is excessive easy you obviously get high and rising inflation. There is only on way of stopping excessive inflation and that is by slowing the money printing press. Instead the Venezuelan government continues to fight inflation with draconian price controls.

The toilet paper shortage is just the latest round of news that confirms the absolutely failed policies of the socialist Venezuelan government, but as usual the government is unwilling to accept any responsibility for the social ills it is causing. Instead the Venezuelan government blames the media:

Commerce minister Alejandro Fleming said “excessive demand” for the tissue had built up due to a “media campaign that has been generated to disrupt the country.”

He said monthly consumption of toilet paper was normally 125 million rolls, but current demand “leads us to think that 40 million more are required”.

“We will bring in 50 million to show those groups that they won’t make us bow down,” he said.

Anybody who have studied economics for 3 minutes of course knows that Fleming’s explanation of the toilet paper shortage is outrageously wrong, but I guess that the Minister himself is unlikely to have problems getting toilet paper supplies himself as the Venezuelan government is massively corrupted and Ministers certainly do not seem to suffer from the social ills that average Venezuelan have to struggle with.

Radical fiscal and monetary reforms are needed 

I have earlier argued that at the core of Venezuela’s economic policies is the fact that the central bank basically has been ordered to finance excessive public spending by letting the printing presses run overtime. There is only one way of stopping the inflation pressures and that is by stopping this monetary funding of public expenditures and then to implement radical monetary reform.

This is reform that I earlier have suggested:

Market Monetarists generally speaking favour nominal GDP targeting or what we also could call nominal demand targeting. For large economies like the US that generally implies targeting the level of NGDP. However, for a commodity exporting economy like Venezuela we can achieve nominal stability by stabilizing the price of the main export good – in the case of Venezuela that is the price of oil measured in Venezuelan bolivar. The reason for this is that aggregate demand in the economy is highly correlated with export revenues and hence with the price of oil.

I have therefore at numerous occasions suggested that commodity exporting countries implement what I have called an Export Price Norm (EPN) and what Jeff Frankel has called a Peg-the Export-Price (PEP) policy.

The idea with EPN is basically that the central bank should peg the country’s currency to the price of the main export good. In the case of Venezuela that obviously would be the price of oil. However, it is not given that an one-to-one relationship between the bolivar and the oil price will ensure nominal stability.

My suggestion is therefore that the bolivar should be pegged to basket of 75% US dollars and 25% oil price. That in my view would view would ensure a considerable degree of nominal stability in Venezuela. So in periods of stable oil prices the Venezuelan bolivar would be more or less “fixed” against the US dollar and that likely would lead to nominal GDP growth in Venezuela that would be slightly higher than in the US (due to catching up effects in Venezuelan productivity), but in periods of rising oil prices the bolivar would strengthen against the dollar, but keep nominal GDP growth fairly stable.

Maybe the toilet paper shortage could convince the new Venezuelan president Maduro to end the Hugo Chavez’s fail policies and implement radical fiscal and monetary reforms – otherwise Venezuela might turn into the smelliest country in the world.

HT Rasmus Ole Hansen

PS This is my blog post #600.

A modest proposal for post-Chavez monetary reform in Venezuela

Let’s just say it as it is – I was very positively surprised by the massive response to my post on the economic legacy of Hugo Chavez. However, as somebody who primarily wants to blog about monetary policy it is a bit frustrating that I attract a lot more readers when I write about dead authoritarian presidents rather than about my favourite topic – monetary policy.

So I guess I have to combine the two themes – dead presidents and monetary policy. Therefore this post on my modest proposal for post-Chavez monetary reform in Venezuela.

It is very clear that a key problem in Venezuela is the high level of inflation, which clearly has very significant negative economic and social implications. Furthermore, the high level of inflation combined with insane price controls have led to massive food and energy shortages in Venezuela in recent years.

Obviously the high level of inflation in Venezuela is due to excessive money supply growth and there any monetary reform should have the purpose of bringing money supply growth under control.

A Export Price Norm will bring nominal stability to Venezuela

Market Monetarists generally speaking favour nominal GDP targeting or what we also could call nominal demand targeting. For large economies like the US that generally implies targeting the level of NGDP. However, for a commodity exporting economy like Venezuela we can achieve nominal stability by stabilizing the price of the main export good – in the case of Venezuela that is the price of oil measured in Venezuelan bolivar. The reason for this is that aggregate demand in the economy is highly correlated with export revenues and hence with the price of oil.

I have therefore at numerous occasions suggested that commodity exporting countries implement what I have called an Export Price Norm (EPN) and what Jeff Frankel has called a Peg-the Export-Price (PEP) policy.

The idea with EPN is basically that the central bank should peg the country’s currency to the price of the main export good. In the case of Venezuela that obviously would be the price of oil. However, it is not given that an one-to-one relationship between the bolivar and the oil price will ensure nominal stability.

My suggestion is therefore that the bolivar should be pegged to basket of 75% US dollars and 25% oil price. That in my view would view would ensure a considerable degree of nominal stability in Venezuela. So in periods of stable oil prices the Venezuelan bolivar would be more or less “fixed” against the US dollar and that likely would lead to nominal GDP growth in Venezuela that would be slightly higher than in the US (due to catching up effects in Venezuelan productivity), but in periods of rising oil prices the bolivar would strengthen against the dollar, but keep nominal GDP growth fairly stable.

 EPN is preferable to a purely fixed exchange rate regime

My friend Steve Hanke has suggested that Venezuela implements a currency board against the dollar and permanently peg the Venezuelan bolivar to the dollar. However, that in my view could have a rather destabilizing impact on the economy.

Imagine a situation where oil prices increase by 30% in a year (that is not usual given what we have seen over the past decade). In that scenario the appreciation pressures on the bolivar would be significant, but as the central bank was pegging the exchange rate money supply growth would increase significantly to curb the strengthening of the currency. That would undoubtedly be inflationary and could potentially lead to a bubble tendencies and an increase the risk of a boom-bust in the economy.

If on the other hand the bolivar had been pegged to 75-25% basket of US dollars and oil then an 30% increase in the oil prices would lead to an appreciation of the bolivar by 7.5% (25% of 30%). That would counteract the inflationary tendencies from the rise in oil prices. Similar in the case of a sharp drop in oil prices then the bolivar would “automatically” weaken as if the bolivar was freely floating and that would offset the negative demand effects of falling oil prices – contrary to what happened in Venezuela in 2008-9 where the authorities tried to keep the bolivar overly strong given the sharp drop in oil prices. This in my view is one of the main cause for the slump in Venezuelan economic activity in 2008-9. That would have been avoided had the Venezuelan central bank operated EPN style monetary regime.

I should stress that I have not done detailed work on what would be the “optimal” mixed between the US dollar and the oil price in a potential bolivar basket. However, that is not the important thing with my proposal. The important thing is that such a policy would provide the Venezuelan economy with an stable nominal anchor while at the time reduce the risk of boom-bust in the Venezuelan economy – contrary to what have been the case in the Chavez years.

Time to get rid of currency and price controls

The massively unsustainable fiscal and monetary policy since 1999 have “forced” the Venezuelan government and central bank to implement draconian measures to control prices and the exchange rate. The currency controls have lead to a large black market for foreign currency in Venezuela and at the same time the price controls have led to massive energy and food shortages in Venezuela.

Obviously one cannot fight inflation and currency depreciation with interventionist policies. Therefore, this policies will have to be abandoned sooner rather than later as the cost of these policies are massive. Furthermore, it is obvious that the arguments for these policies will disappear once monetary policy ensures nominal stability.

End monetary funding of public finances

A key reason for the high level of inflation in Venezuela since 1999 undoubtedly has to be explained by the fact that there is considerable monetary financing of public finances in Venezuela. To end high-inflation it is therefore necessary to stop the central bank funding of fiscal policy. That obviously requires to bring the fiscal house in order. I will not touch a lot more on that issue here, but obviously there is a lot of work to be undertaken here. A place to start would obviously be to initiate a large scale (re)privatization program.

A modest proposal for monetary reform

We can therefore sum up my proposal for monetary reform in Venezuela in the following four points:

1) Introduce an Export Price Norm – peg the Bolivar to a basket of 75% US dollars and 25% oil prices

2) Liberalize capital and currency controls completely

3) Get rid of all price and wage controls

4) Separate fiscal policy and monetary policy – stop monetary funding of the public budget

I doubt that this post will be popular as my latest post on Venezuela, but I think that this post is significantly more important for the future well-being of the Venezuelan economy and a post-Chavez regime should move as fast as possible to implement monetary reform because without monetary reform the Venezuelan economy is unlikely to fully recover from its present crisis.

—-

Jeffrey Frankel has made a similar proposal for the Gulf States. Have a look at Jeff’s proposal here.

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Update: Steve Hanke has a comment on his suggestion for full dollarization in Venezuela. Even though I prefer my own EPN proposal I must say that Steve’s idea has a lot of appeal given the obvious weakness of public institutions in Venezuela and a very long history (pre-dating Chavez) of monetary mismanagement.

Hugo Chavez’s economic legacy – the two graph version

Today (March 5th) – on the 60 year anniversary of Stalin’s death – Venezuelan president Hugo Chavez passed away.

I think Chavez’s economic legacy can be pretty well-illustrated by two graphs comparing Venezuela’s economic performance from 1999 when Chavez became president with three ‘neo-liberal’ Latin American countries – Chile, Peru and Colombia.

We start out with the real GDP level (Index 1999 = 100)

LATAM RGDP

And next the price level (GDP deflator, Index 1999 = 100)

LATAM inflation

I leave it to my readers to judge whether Hugo Chavez’s death is a positive or a negative shock to Venezuela’s economy.

PS I am not claiming that Venezuelan economic statistics has not been manipulated. My source is IMF.

Related posts:
Food shortage is always and everywhere a monetary phenomenon
A modest proposal for post-Chavez monetary reform in Venezuela

I don’t care who becomes BoJ governor – I want better monetary policy rules

UPDATE: I have edited my post significantly – I misread what Scott really said. That is the result of writing blog posts very early in the morning after sleeping too little. Sorry Scott…

Scott Sumner has a blog post on who might become the next governor of Bank of Japan. Scott ends his post with the following comment:

Naturally I favor the least dovish of the three.

Note that Scott is saying “least dovish” (I missed “least” in my original post). But don’t we want a the most dovish BoJ governor? No, we want the most principled governor – or rather the governor most committed to a rule based monetary policy.

The debate over doves versus hawks is a debate among people who fundamentally think about monetary policy in a discretionary fashion. Market Monetarism is exactly the opposite. We are strongly against discretion in monetary policy (and fiscal policy for that matter).

The important thing is not who is BoJ governor – the important thing is that there are good institutions – good rules. As I have argued before – what we really want is a monetary constitution in spirit of Jim Buchanan. In that sense the BoJ governor should be replaced – as Milton Friedman suggested – by a ‘computer’ and not by the most ‘dovish’ candidate.

Market Monetarists would have been “hawks” in the 1970s in the sense that we would have argued that for example US monetary policy was far too easy and we are ‘doves’ now. But that is really a mistaken way to think about the issue. If we favour for example a 5% NGDP level target for the US today – then we would have been doves in 1974 or 1981. That would make us more or less dovish/hawkish at different times, but that debate is for people who favours discretionary monetary policies – not for Market Monetarists.

If we just want a ‘dovish’ BoJ governor then we should advocate that Prime Minister Shinzo Abe gives Zimbabwean central bank governor Gideon Gono a call. He knows all about monetary easing – and so do the central bank governors of Venezuela and Argentina. But we all know that these people are ludicrously bad central bankers.  In similar fashion Janet Yellen would not be the Market Monetarist candidate for the Federal Reserve chairman just because she tends to favour monetary easing – in fact it seems like Yellen always favours monetary easing. In fact you should be very suspicious of the views of policy makers who will always be hawks or doves.

Gideon_Gono10

The reason that Mark Carney is a good choice for new Bank of England governor is exactly that he is not ‘dovish’ or ‘hawkish’, but that he tend to stress the need for a rule based monetary policy. That said, the important thing is not Mark Carney, but rather whether the UK government is serious about introducing NGDP level targeting or not.

Monetary policy is not primarily about having the right people for the job, but rather about having the best institutions. Obviously you want to have the best people for the job, but ultimately even Scott Sumner would be a horrible Fed governor if his mandate was wrong.

If the BoJ had a rule based monetary policy and used for example NGDP futures to conduct monetary policy then it wouldn’t matter who becomes BoJ governor – because the policy would be the same no matter what. We cannot rely on central bankers to do the ‘right thing’. Central bankers only do the right thing by chance. We need to tie their hands with a monetary constitution – with strong rules.

Related posts:

Forget about “hawks” and “doves” – what we need is a “monetary constitution”
NGDP targeting is not about ”stimulus”
NGDP targeting is not a Keynesian business cycle policy
Be right for the right reasons
Monetary policy can’t fix all problems
Boettke’s important Political Economy questions for Market Monetarists
NGDP level targeting – the true Free Market alternative
Lets concentrate on the policy framework
Boettke and Smith on why we are wasting our time
Scott Sumner and the Case against Currency Monopoly…or how to privatize the Fed
NGDP level targeting – the true Free Market alternative (we try again)

 

Argentina’s hidden inflation – another case of the horrors of price controls

In my previous post I discussed how price controls likely have created a wedge between inflation measured by CPI and by the GDP deflator in Malaysia. That made me think – can we find other examples of this in the world? And sure thing the story of Argentina’s inflation over the last decade seem to be more or less the same thing.

The graph below shows Argentine inflation measured by CPI and the GDP deflator since 2002. The difference is very easy to spot.

It is very clear that until 2005 the two measures of inflation tracks each other quite closely, but from 2005 a difference opens up. So what happened in 2005? Well, the story is exactly as in Malaysia – monetary policy is inflationary and the government tries to curb inflation not by printing less money, but by introducing price controls.

Here is a story from Bloomberg November 24 2005:

Argentine President Nestor Kirchner accused supermarkets of price fixing and said he would increase controls to slow a surge in inflation.

Kirchner, in a televised speech at the presidential palace, said agreements between supermarkets such as Coto CISA SA and Hipermercados Jumbo SA, a unit of Chilean retailer Cencosud SA, to increase prices would lead to 12 percent inflation next year. In the 12 months through October Argentina’s consumer prices rose 10.7 percent, the fastest rate of increase in 29 months.

“We will fight to defend consumers’ pockets,” Kirchner said, without specifying how he would slow price increases.

The accusation underscores the government’s concern over quickening inflation, which may increase poverty in a country where almost 50 percent of the population cannot afford to cover their food and other basic needs, said economist Rafael Ber of Argentine Research brokers in Buenos Aires.

Rising prices may also hurt the ability of Argentine producers to compete with foreign goods, Ber said.

Kirchner has already attacked private companies for increasing prices. In April, he called on consumers to boycott The Royal Dutch Shell Group after the energy company increased prices.

So there you go – price controls in response to inflation. That is never good news and the result has been the same in Argentina as in Malaysia (actually it is much worse) – shortages (See also my previous discussion of food shortages in Venezuela and Argentina here).

Price controls always have the same impact – shortages – and if you think Malaysia and Argentina are the only countries in the world to make this kind of policy mistakes think again. Here is from the US, where a Republican governor these days is experimenting with price controls and the result is the same as in Argentina and Malaysia – shortages!

PS it should be noted that the Argentine inflation data very likely is manipulated so there is more to it than just price controls – we also has a case of the books being cooked. See more on that here.

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